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ADV PART II
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Market Commentary

Housing, Fiscal C. & Dennis G.
December 02, 2012  David R. Kotok, Chairman and Chief Investment Officer

The absurdity of this fiscal cliff debate ignores vital questions. Does the federal government allocate resources well, or poorly?  Does the private market do it better, or worse?  And what should be the balance between the two?  With what degree of regulation by the government?  These are profound questions about which our political leaders are nearly silent.

President Obama’s class warfare, aimed at taxing the rich, avoids these tough questions.  Republican leaders avoid them, too, with their counterpoints about raising revenue without raising actual tax rates.  Neither side serves the country well; they do not debate the more fundamental issue about the role of government.

Let’s look at these questions in the context of housing.

Federal policy changed after World War II.  Our nation agreed to help returning veterans buy homes.  The first government-subsidized (guaranteed) mortgages in the postwar period were for veterans.  That national policy of assistance for veterans still has major support and few detractors.

Over time, the federal government misused its ability to allocate resources to housing.  Fannie Mae ended up a national disaster.  The old-style local lender (savings and loans) disappeared.  The price for this federal allocation of housing resources eventually tallied in the hundreds of billions when it blew up.  The housing collapse and the financial crisis associated with it have cost trillions in losses.

We are still unwinding the housing finance mess and its aftermath; but the private markets are clearing.  Why?  Not because of any fiscal program.  It is the Fed that provides the healing.  The Federal Reserve’s low-interest-rate policy focused on mortgages is facilitating the repair of the housing sector.

Consider these facts.  In the middle of 2009, as the worst recession in modern times was ending, 46 of the 50 states had falling house prices.  In Nevada the plunge was 28%.  Arizona 21%.  Florida 18%.  California 15%.  Sources: Federal Housing Finance Agency, Ned Davis database.

Now, 44 states show rising house prices.  Arizona is up 20%.  Nevada is up 9%.  California 7%.  Florida 7%.  Data is the four-quarter change by state: Purchase-Only Index (seasonally adjusted).  The most recent time period reported is Q3 2011 - Q3 2012.

Housing is definitely recovering. 

The Fed’s policy of low mortgage rates certainly helps.  Fannie’s role is limited, although it still dominates the mortgage business by crowding out most others.  And it still employs the implied federal guarantee, while the federal debt limit debate and fiscal cliff discussion ignore the reality of $5 trillion in federally-assisted housing finance.  You have not heard clarity from Washington about the contingent liabilities of the United States.  The Obama, Boehner, Reid, McConnell, Pelosi nexus pretend these contingent liabilities do not exist.

Now we have another federal housing finance mess unfolding.  This, too, is an example of federal misallocation of resources and failure of federal policy, followed by federal cover-up through rule making.  This, too, is an example of the Obama Administration’s tactic of ignoring and postponing an inevitable financial cost and thereby exacerbating it.  This, too, shows how Republicans fail to argue their case honestly and persuasively.

We are talking about the mess at FHA.

My friend Dennis Gartman does not mince words.  He captured things perfectly in the November 30 issue of his eponymous daily letter which, by the way, we read regularly.  Thank you, Dennis, for calling it as you see it and for giving us permission to share the letter with our readers.

The November 30, 2012 edition of The Gartman Letter said:

“The Federal Housing Administration finds itself in rather dire fiscal circumstances as mortgage after mortgage after mortgage that it made to people who should never have been given a mortgage are defaulting every hour.  17% of the FHA’ mortgages are now delinquent and this is a shocking number.” 

So what is the Obama Administration doing about it, asks Dennis. 

“Well it is extending the so-called grace period being allowed to its mortgagees. Starting in August of last year, the FHA began extending this grace period, giving dead beats a longer period of time in which to beat dead. Now, if you are unemployed but have an FHA guaranteed or issued mortgage you can miss a full year’s payments and not be considered delinquent… up from what we considered an already far-too-lenient 3 months. After a year in the grace period if no payments are received, the FHA will begin foreclosure. However, as we understand it, if one payment is made before the twelve months is up, the mortgage is considered current and the clock begins again.”

Dennis concludes, “Really, you cannot make this stuff up. What we have then is a growing pool of mortgagees who know that their house shall eventually be foreclosed upon and thus whose upkeep on the house diminishes with each missed payment. As one prescient economist once said, ‘Never in history has a rented car been returned waxed.’ Always in history ‘renters’ treat houses more poorly than owners, and owners not making payments are not even renters… they are merely squatters.”

Readers, please note that billions of accumulated federal liabilities and contingent guarantees are at stake here.  None of this federal liability is part of the current fiscal cliff debate.

In spite of problems on the fiscal side of the federal government, housing is recovering.  The Fed’s low-interest-rate policy will continue until housing reaches a normalized baseline, and that is still years away.  For investment markets, the implications are huge.  We continue to be overweight the housing-related ETFs, such as XHB.  We have held XHB for over a year.

We believe this housing recovery cycle will run the entire rest of the decade.  The housing ETFs have a survivor bias.  The failed homebuilders are not around any more.  We remain fully invested.

David R. Kotok, Chairman and Chief Investment Officer

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